Deflation Fears Send Investors Searching for Bonds, Dividends

The anticipation of a sustained economic slowdown has brought the deflationary trade back into view and highlighted the need for good yields and relative safety.

What's Next?

Tuesday's producer prices report showing a drop of 0.1 percent, coupled with a sharp decline in building permits, reinforced the notion that the recovery could be slow going from here on.

Add in the debt problems from Greece and its neighbors, the sharp decline of the euro and corresponding rise of the dollar, and the withdrawal of stimulus and quantitative easing from the Federal Reserve, and the equation isn't hard to solve for some investors.

Deflation combines slow economic growth with no inflation, which is generally bad for stocks and good for bonds.

"Short-term you've got a little bit left in stocks. Ultimately in a deflationary environment bonds are the place to be," says Keith Springer, president of Capital Financial Advisory Services in Sacramento, Calif. "The pros see deflation. What do you do in a low-interest environment? You buy bonds."

Indeed, investors have turned their gaze strongly to bonds, boosting both corporates and Treasurys as the stock market has continues to wobble.

Long-term government debt has fared particularly well, with the iShares Barclays 20+ Year Treasury exchange-traded fund up about 3.4 percent in May. The 30-year bond has seen its yield drop a quarter percentage point, from 4.53 at the start of the month to 4.28 in afternoon trading Tuesday.

"Everyone thinks the Treasury auctions are going to fail. That's why they're exceeding estimates," Springer says. "I'm not a fan of Treasurys. I don't think there's enough return. But if you're a sovereign nation with trillions in liquidity you've got to put your money somewhere, so they buy Treasurys."

Fixed income performs well in times of economic slowness and low interest rates because its value isn't eaten away by inflation.

That belief seems to be justified by velocity of money metrics from the Federal Reserve.

While M1 money supply—or total currency minus bank reserves—grew 5 percent through April, its M2 counterpart actually has been waning. Considered a key inflation measure, M2 is a closer measure of money in circulation and declined 0.3 percent during the same period, according to the Federal Reserve.

Another key indicator of inflation, the 10-year Treasury note yield, has contracted from 3.72 at the beginning of the month to 3.40 Tuesday.

With few expectations that the Federal Reserve will take any drastic rate action in the wake of global financial turmoil, investors are getting more comfortable with the notion that bonds can still work, despite concern just a few weeks ago that a new bear market was setting in.

But that doesn't mean investors are ready to get out of stocks.

Rather, the focus now could turn away from broad market momentum purchases and more towards companies that pay strong dividends and are protected from economic storms.

"You sidestep it for a while, but by no means do you leave higher-risk asset classes," says Joe Balestrino, fixed income strategist at Federated Investors in Pittsburgh. "When you get past the headlines and people realize that Greece is not bringing down the world, then these things snap back pretty hard."

The best-performing stocks in May in terms of dividend and stock price gains compared to the Standard & Poor's 500 are Hasbro, PPL, Sara Lee, General Mills and Procter & Gamble.

But should deflation take a stronger hold than expected, one strategist is encouraging investors to get out of risk completely and stick with currency.

The Deflation Trade

Best trades in a deflationary environment, with Stuart Freeman, of Wells Fargo Advisors, and Todd Colvin, of MF Global.

"The risk ahead is not a 'double dip' recession. The risk ahead is a global deflationary implosion, in which case the US dollar stands to be the prime beneficiary," Walter J. Zimmerman, chief strategist at United/ICAP, wrote in an analysis for clients.

Zimmerman has a strongly bearish view of the economy, suggesting that the "flash crash" of May 6 that sent the Dow off nearly 1,000 points was a warning shot. He asserts the best-case scenario is for a market swoon that will take the S&P 500 down to 878, with the worst-case scenario pulling the index all the way down to 330.

"From here we can see no technical justification whatsoever for having any length in the stock market," Zimmerman said. "We suggest that those still in the stock market evacuate. And if you feel the need to buy something, we suggest buying puts."

Other analysts, though, feel investors are following a herd mentality in believing deflation is in the works and ought to be taking a more contrarian view of things.

Alan Lancz, president of Alan B. Lancz and Associates in Toledo, Ohio, says he is shorting Treasurys and thinks the market is in a short-term pullback from oversold highs.

"Buy into weakness selectively is the smartest thing," he says. "Buy high-quality companies that are buying back shares and increasing dividend with good cash flow and have good balance sheets that can whether this storm."